Incentives versus Transaction Costs: A Theory of Procurement Contracts

Rand Journal of Economics 32, no. 3 (Autumn 2001): 387-407
Incentives versus Transaction Costs: A Theory of Procurement Contracts
Patrick Bajari
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Abstract

Inspired by facts from the private-sector construction industry, we develop a model that explains many stylized facts of procurement contracts.

The buyer in our model incurs a cost of providing a comprehensive design and is faced with a tradeoff between providing incentives and reducing ex post transaction costs due to costly renegotiation. We show that cost-plus contracts are preferred to fixed-price contracts when a project is more complex.

We briefly discuss how fixed-price or cost-plus contracts might be preferred to other incentive contracts. Finally, our model provides some microfoundations for ideas from Transaction Cost Economics.

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